International GAAP® 2019: Generally Accepted Accounting Practice under International Financial Reporting Standards
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insignificant or not. If the difference is deemed to be significant then the portfolio would
need to be classified as debt instruments at fair value through profit and loss. In contrast,
an instrument which is prepayable at fair value does not fall under the exception stated
above (see discussion at 6.4.4.A above).
The following examples illustrate further instruments with contractual features that
modify the timing and amount of contractual cash flows such that the instruments pass
the contractual cash flow characteristics test. Some examples include possible changes
to the fact pattern which may change that assessment.
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Example 44.21: Debt covenants
A loan agreement contains a covenant whereby the contractual spread above the benchmark rate will increase
if the borrower’s earnings before interest, tax, depreciation and amortisation (EBITDA) or its debt-to-equity
ratio deteriorate by a specified amount by a specified date.
Whether this instrument passes the contractual cash flow characteristics test depends on the specific terms.
The loan would pass the contractual cash flow characteristics test if the covenant serves to compensate the
lender for taking on a higher credit or liquidity risks.
However, if the covenant results in more than just credit or liquidity protection, or provides for an increase in
the rate of return which is not considered appropriate under a basic lending arrangement, the instrument will fail
the test. For example, an increase in interest rate to reflect an increase in EBITDA would not satisfy the criteria.
Example 44.22: Auction Rate Securities (ARSs)
ARSs have long-term maturity dates but their interest rate resets more frequently based on the outcome of an
auction. As a result of the auction process, the interest rates are short-term and the instruments are treated
like short-term investments.
In the event that an auction fails (i.e. there are insufficient buyers of the bond to establish a new rate), the rate
resets to a penalty rate. The penalty rate is established at inception and does not necessarily reflect the market rate
when the auction fails. It is often intended to compensate the holder for the instrument’s lack of liquidity as
demonstrated by the auction failure. The auction process for many such securities failed during the financial crisis.
The classification at initial recognition should be based on the contractual terms over the life of the
instrument. Although the presumption on acquisition may have been that the auctions were not expected to
fail, the potential penalty rate should still be taken into account in the assessment of the instrument’s
characteristics at initial recognition. If the penalty rate could be considered to compensate the holder for the
longer-term credit risk of the instrument following the auction failure as a result of a reduction in market
liquidity, it may be possible that the penalty rate reflects interest. However, as such instruments usually have
multiple issues with different penalty rates, each different case would need to be carefully evaluated before
a conclusion could be reached.
6.4.5
Contractual features that normally do not represent payments of
principal and interest
In some cases, financial assets may have contractual cash flows that are not solely
payments of principal and interest. [IFRS 9.B4.1.14]. Unless such a feature is de minimis or
non-genuine, the instrument would fail the contractual cash flow characteristics test.
[IFRS 9.B4.1.18]. Examples of such instruments with contractual cash flows that may not
represent solely payments of principal and interest include instruments subject to
leverage and instruments that represent investments in particular assets or cash flows.
Leverage is a contractual cash flow characteristic of some financial assets. It increases
the variability of the contractual cash flows with the result that they do not have the
economic characteristics of just principal and interest. Stand-alone option, forward and
swap contracts are examples of financial assets that include such leverage. Thus, such
contracts fail the contractual cash flow characteristics test and cannot be measured at
amortised cost or fair value through other comprehensive income. [IFRS 9.B4.1.9].
However a variable rate asset at a deep discount will not normally fail the contractual
cash flow characteristics test. When the IASB deliberated the meaning of principal in
September 2013 they did not distinguish between fixed and variable rate assets and do
not seem to have intended a variable rate plain vanilla instrument to fail the contractual
cash flow characteristics test. Moreover, a variable rate asset which is acquired or
originated at a deep discount will normally be a purchased or originated credit impaired
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asset. As such, the effective interest rate used will be the credit-adjusted effective
interest rate. In these cases the borrower will usually be unable to pay any increases in
rates and any decrease in rates would result in the borrower repaying more principal.
Either way, the loan is essentially fixed rate and, therefore not leveraged, so will not fail
the contractual cash flow characteristic test.
Example 44.23: Dual currency instruments
For some financial assets the interest payments are denominated in a currency that is different from the
principal of the financial asset. IFRS 9 requires the assessment of ‘whether contractual cash flows are solely
payments of principal and interest on the principal outstanding for the currency in which the financial asset
is denominated’. [IFRS 9.B4.1.8].
This implies that any instrument in which interest is calculated based on a principal amount other than that
payable on maturity will not pass the contractual cash flow characteristics test. For instance, if variable
interest payments are computed based on a fixed principal amount in another currency, e.g. US dollars,
although repayment of the principal is in sterling, the financial asset is not considered to have cash flows that
are solely payments of principal and interest.
However, there may be instances where interest is denominated in a currency that is different from the
principal currency, but the contractual cash flows could possibly constitute solely payments of principal and
interest. For example, the principal amount of the bond is denominated (and redeemed at a fixed maturity) in
Canadian dollars (CAD). Interest payments are fixed in Indian Rupees (INR) at inception based on the market
interest rates and foreign exchange spot and forward rates at that time.
While not explicit in the standard, in our view, if the bond can be separated into two components that, on
their own, would meet the contractual cash flow characteristics test, then the combined instrument would do
so. That is, if the bond can be viewed as the combination of a zero-coupon bond denominated in CAD and a
stream of fixed payments denominated in INR, and if both instruments can be analysed as a stream of cash
flows that are solely payments of principal and interest, then the sum of the two would do so as well.
The defining criterion is the fact that the interest payments have been fixed at inception and there is no
exposure to changes in cash flows in the currency of denomination of the cash
flows.
Example 44.24: Convertible debt
An entity holds a bond that is convertible into equity instruments of the issuer.
The holder would analyse the convertible bond in its entirety, since IFRS 9 does not separate embedded
derivatives from financial assets.
The contractual cash flows are not payments of principal and interest on the principal amount outstanding
because they reflect a return that is inconsistent with a basic lending arrangement (see 6 above) i.e. the return
is also linked to the value of the equity of the issuer. [IFRS 9.B4.1.14 Instrument F].
The assessment would change if the issuer were to use its own shares as ‘currency’. That is, if the bond is
convertible into a variable number of shares with a fair value equal to unpaid amounts of principal and interest on
the principal amount outstanding. In this case, the bond might satisfy the contractual cash flow characteristics test
and would be derecognised on conversion. However, such conversion features are often capped because,
otherwise, the issuer could be required to deliver a potentially unlimited amount of shares. The existence of such
a cap, if genuine, would result in the failure of the test. Additionally the use of a volume weighted average price
approach to calculating the fair value of the shares at the conversion date could also result in the failure of the test.
Example 44.25: Inverse floater
An entity holds a loan that pays an inverse floating interest rate (i.e. the interest rate has an inverse
relationship to market interest rates, such as 6% minus 2 times LIBOR).
The contractual cash flows are not solely payments of principal and interest on the principal amount
outstanding because an inverse floating rate does not represent consideration for the time value of money.
[IFRS 9.B4.1.14 Instrument G].
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Example 44.26: Perpetual instruments with potentially deferrable coupons
An entity holds a perpetual instrument but the issuer may call the instrument at any time, paying the holder
the par amount plus accrued interest due.
The instrument pays interest but payment of interest cannot be made unless the issuer is able to remain solvent
immediately afterwards. There are two scenarios.
Scenario a) interest is accrued on the deferred amounts.
The contractual cash flows could be payments of principal and interest on the principal amount outstanding.
An example in the standard states that the fact that the instrument is perpetual does not in itself mean that the
contractual cash flows are not payments of principal and interest on the principal amount outstanding. In
effect, a perpetual instrument has continuous (multiple) extension options. Such options may result in
contractual cash flows that are payments of principal and interest on the principal amount outstanding if
interest payments are mandatory and must be paid in perpetuity.
Some may find it strange that the instrument is deemed to satisfy the contractual cash flow characteristics
test even though the principal will never actually be paid. Also, the fact that the instrument is callable does
not mean that the contractual cash flows are not payments of principal and interest on the principal amount
outstanding, unless it is callable at an amount that does not substantially reflect payment of outstanding
principal and interest on that principal amount outstanding. Even if the callable amount includes an amount
that reasonably compensates the holder for the early termination of the instrument, the contractual cash flows
could be payments of principal and interest on the principal amount outstanding. (See 6.4.4 above).
Scenario b) deferred interest does not accrue additional interest.
The contractual cash flows are not payments of principal and interest on the principal amount outstanding.
This is because the issuer may be required to defer interest payments and additional interest does not accrue
on those deferred interest amounts. As a result, interest amounts are not consideration for the time value of
money on the principal amount outstanding.
Note that, in this example, the holder is not entitled to assess whether it is probable that interest may ever be
deferred. As long as the feature is genuine, the deferral of interest must be taken into account in assessing
whether interest amounts are consideration for the time value of money on the principal outstanding.
[IFRS 9.B4.1.14 Instrument H].
Example 44.27: Write-down or conversion imposed by regulator
Scenario a) the provision is not a contractual feature
A regulated bank issues an instrument with a stated maturity date. The instrument pays a fixed interest rate
and all contractual cash flows are non-discretionary.
However, the issuer is subject to legislation that permits or requires a national resolution authority to impose
losses on holders of particular instruments, including the above mentioned instrument, in particular
circumstances. For example, the national resolution authority has the power to write down the par amount of
such an instrument or to convert it into a fixed number of the issuer’s ordinary shares if the national resolution
authority determines that the issuer is having severe financial difficulties, needs additional regulatory capital
or is failing.
The holder would analyse the contractual terms of the financial instrument to determine whether they give
rise to cash flows that are solely payments of principal and interest on the principal amount outstanding and
thus are consistent with a basic lending arrangement.
According to the standard, this analysis would not consider the write-down or conversion that arise only as
a result of the national resolution authority’s power under statutory law to impose losses on the holders of
such an instrument. That is because that power is not a contractual term of the financial instrument.
Although this example makes use of a principle that is widely applied, we note that it is not consistent with
the position taken in IFRIC 2 – Members’ Shares in Co-operative Entities and Similar Instruments, which
requires an entity to include ‘relevant local laws, regulations and the entity’s governing charter in effect at
the date of classification’ when classifying a financial instrument as a liability or equity.
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Scenario b) the provision is a contractual feature
The contractual terms of the financial instrument permit or require the issuer or another entity to impose
losses on the holder (e.g. by writing down the par amount or by converting the instrument into a fixed number
of the issuer’s ordinary shares), if the issuer fails to meet particular regulatory capital requirements (a non-
viability event).
Provided the ‘non-viability’ provision is genuine, which will normally be the case, the instrument will fail
the contractual cash flow characteristics test even if the probability is remote that such a loss will be imposed.
[IFRS 9.B4.1.13 Instrument E].
Note that payments that arise as a result of a regulator’s statutory power and that are
either only referenced or not mentioned in the contractual terms of the instrument are
not considered in the analysis of the contractual payment features of the instrument.
Example 44.28: Multiple of a benchmark interest rate
An entity holds an instrument for which the interest rate
is quoted as a multiple of a benchmark interest rate
(e.g. 2 times 3-month EURIBOR for a 3-month term).
Such features introduce leverage and the standard is explicit that leverage increases the variability of the
contractual cash flows, resulting in them not having the economic characteristics of interest. As a result, such
instruments would need to be measured at fair value through profit or loss. [IFRS 9.B4.1.9].
Example 44.29: Fixed rate bond prepayable by the issuer at fair value
A company acquires a bond which requires the issuer to pay a fixed rate of interest and repay the principal
on a fixed date. However, the issuer has the right to prepay (or call) the bond before maturity, although the
amount the issuer must pay is the fair value of the bond at the time of prepayment, i.e. the fair value of the
contractual interest and principal payments that remain outstanding at the point of exercise. For example, if
the bond has a term of five years and the call option is exercised at the end of the second year, the fair value
would be calculated by discounting the principal and interest payments due over the remaining three years at
the current market interest rate for a three-year bond with similar characteristics.
The exercise price represents the fair value of unpaid amounts of principal and interest on the principal
amount outstanding at the date of exercise, albeit discounted at the current market interest rate rather than
the original market interest rate.
The fact that the exercise price is the fair value could be interpreted as providing reasonable additional
compensation to the holder for early termination in a scenario, although this holds true only where the market rate
has fallen since the issue of the bond. If interest rates rise, the holder will not receive additional compensation for
early termination and will receive less than the principal amount. In these circumstances, due to the negative
compensation, the bond holder would not be receiving principal and interest, however prepayments with negative
compensation can meet the contractual cash flows characteristics test (see 6.4.4.A above).
Example 44.30: Investment in open-ended money market or debt funds
In an open-ended fund, new investors are accepted by the fund after inception and existing investors have